IPO grading: Back to basics

IPO Grading is a new concept launched in mid-2007 by CRISIL. While it is unique to India, the underlying philosophy - the need for independent research in equity has been recognised in several other markets.

In the US, for instance, fines raised through the Spitzer settlement early this decade were used to pay for independent equity research. Similarly, Malaysia’s stock exchanges pay for independent research on listed companies.

IPO grading is a tool that provides an independent opinion on companies going public for the first time. There traditionally exists little or no information or research on these unlisted entities for retail investors.

And these investors more often than not, lack the resources to carry out adequate research on their own before investing. In a move aimed at enabling investors obtain an unbiased opinion on fundamentals of IPOs in India, Sebi made IPO Gradings mandatory in May 2007.

The objective was to provide simply-expressed opinions on the issuing companies that lay investors could base their decisions upon. IPO Grading fills this gap, with an easily understood and self-explanatory grade from 1 to 5, available free to the investing public.

This grade indicates how strong the fundamentals (essentially the intrinsic quality of the company as measured by its business prospects, financial strength, corporate governance and management quality) of the graded company are in relation to listed Indian companies.

CRISIL makes IPO grades available free of charge to all investors on its website. The grades are also displayed in the company’s IPO prospectus, advertisements and application forms.

While there is consensus among market participants that an independent opinion by a credible agency does benefit the market, there have been whispers that the value to investors is questionable as an IPO grading does not provide a view on the issue price and it does not directly recommend whether the investors should subscribe to the proposed IPO.

Why does an IPO grading stop at fundamentals? Why can’t it take the next step and actually recommend an investment decision (buy/don’t buy) to investors? For this, let us understand the components of an investment decision. An investment decision stems from three basic components, an analysis of fundamentals, an analysis of returns and investor preferences.

While an analysis of returns (does the upside potential match the investor’s return expectation?) and investor preference (for example, is he/she already overexposed to the specific asset class/sector) are very specific to the individual, the fundamentals of a company are uniform across every class of investors.

Thus, what is a ‘buy’ for a 25-year-old may not be appropriate for a 57-year-old, even as product attributes and quality are constant. An all-encompassing ‘buy’ or ‘don’t buy’ opinion can therefore mislead investors. At the fundamental level, however, there can be no ambiguity: what is fundamentally good or bad is fundamentally good or bad for all categories and classes of investors!

What then should an investor do after seeing the IPO grade? Having satisfied yourself as to the quality of fundamentals through IPO grading, investors should proceed to analyze whether the pricing of the issue is in line with its quality. This can be done by looking at the pricing of other peers in the secondary market. This combination of fundamentals obtained from the IPO grade and the investor’s own analysis of returns should lead to an investment decision by the investor.

A common refrain is, “how come an issue graded 1/5 (weak fundamentals) was subscribed several times over? And on listing, opened at double the price? How did the 4/5 company open so low? Does this mean your grading is wrong?” The answer is a resounding no. The price on listing or the extent of oversubscription or the grey market premium are all a function of various factors including pricing of the IPO and market sentiment. IPO grading is not a tool for investors (speculators?) looking for short-term listing profits and it cannot be judged based on what happens when an IPO lists. IPO grading is a very useful tool for a serious investor looking to make stock picks of fundamentally sound companies from a long term perspective.

Caveat emptor - if you are investing your hard-earned money, you must understand what you are buying. An IPO grading can give you the benefit of an expert opinion on the prospects of the company, quality of management and corporate governance completely free of cost. So, while investing, refer to the IPO grade, factor in your return expectations and preferences and make an empowered, informed and sound investment decision.